Stock Market Returns, Corporate Governance and Capital Market Equilibrium

Abstract

This paper analyzes why corporate governance matters for stock returns if the stock market prices the underlying managerial agency problem correctly. Our theory assumes that strict corporate governance prevents managers from diverting cash flows, but reduces incentives for managerial effort. In capital market equilibrium, this trade-off has implications for the firm's earnings, stock returns, and managerial ownership, because governance impacts the firm's risk-return structure. In particular, the strictness of corporate governance is negatively related to earnings and positively to s;. Various empirical tests with U.S. data using the governance index of Gompers, Ishii, and Metrick (2003) yield results consistent with these predictions.